China Unswayed by Downgrade

China is unlikely to make major changes to its investment policies as a result of the downgrade in U.S. debt, experts say.

"The Chinese are caught between a rock and a hard place," said Harvard University economist Dale Jorgenson. "They don't have any good alternatives for investing all their accumulated foreign reserves."

Beijing has leveled sharp criticism at the United States since Standard & Poor's lowered its long-term U.S. credit rating on Aug. 5.

"The world has seen enough useless bipartisan debate. The bond-holders are losing confidence," said the official Xinhua news agency in an angry commentary with a New York dateline on Aug. 7.

But the market's immediate response was just the opposite. On the first day of trading, Treasury prices surged as investors dumped stocks for the safety of U.S. debt.

Yields on 10-year T-bills, which move inversely with prices, dipped below 2.34 percent due to soaring demand, while rates on two-year bills dropped to an all-time low, Bloomberg News said.

On Aug. 10, the Treasury easily sold $24 billion of 10-year notes to eager investors at a record low rate of 2.14 percent.

By the second day of last week's market turmoil, China's statements had adopted a more measured tone. A State Council meeting called by Premier Wen Jiabao called on "relevant nations" to maintain market stability, Xinhua said.

Heavy reliance

China's concern is a symptom of its heavy reliance on U.S. creditworthiness.

At the end of April, the country held $1.15 trillion in Treasury bills, or 36 percent of its foreign currency reserves. Some 70 percent of China's $3.2 trillion is
invested in dollar-denominated assets, Reuters said.

But despite the one-notch downgrade from AAA to AA-plus, U.S. debt seems to be just as sound an investment as before.

"Treasuries will remain the world's gold standard," said Abdullah Karatash, head of U.S. bond trading, at investment firm Natixis in New York, the Wall Street Journal reported.

In an interview, Harvard's Jorgenson said China's money also has very few other safe places to go.

The rating may strengthen China's tendency to diversify its holdings into euros, but that currency is struggling as debt concerns shift from smaller economies like Greece and Portugal to larger ones like Italy, Spain and France.

Last week's market volatility was due more to fears about European finances than worries about the U.S. rating, said Jorgenson.

"If they think the euro is about to collapse, that means that their only realistic alternative to the dollar is the Japanese yen," he said.

But China would face worries on that front, as well. It may be wary of relying on quake-stricken Japan, where yields are low and regulators are reluctant to boost the money supply.

"Their options are very limited," said Pieter Bottelier, a former World Bank official, now a nonresident scholar at the Carnegie Endowment for International Peace.

"Don't expect the Chinese to do suddenly totally wild things with respect to their foreign exchange reserve investments or the composition thereof," he told RFA. "That would be both unwise and countercultural, because they are very cautious."

Bottelier agrees that U.S. debt is still likely to be the safest of havens for China's reserves.

"For the time being, U.S. Treasuries will remain a preferred investment instrument—the best, the safest, the largest, the most liquid market," he said. "That has not changed as a result of the downgrade."

After a series of wild swings, the Dow Jones Industrial Average ended last week with a modest decline of 1.5 percent from its pre-downgrade level, while the yield on 10-year Treasuries settled at 2.237 percent.

Equities or commodities' option

University of Pittsburgh economist Thomas Rawski also sees little effect on China's strategies, although he suggested it may have the option of investing in equities or commodities, as some sovereign wealth funds have done.

Some commentators believe a push for investment in commodities is inevitable, driving up China's inflation, which has already hit a 37-month high of 6.5 percent in July.

"The most serious problem in the short term is inflation, which will get worse as investors shift away from U.S. dollars and into commodities," wrote Shaun Rein of China Market Research Group on cnbc.com.

But fears of greater inflation could also be a reason why China would avoid speculation in commodities, which would create more upward pressure on its own prices.

None of the alternatives offers an adequate avenue for the massive amounts of cash that the People's Bank of China (PBOC) has to invest.

"They are so large, they have so much foreign exchange in reserves, it's very difficult for them to do things that don't wind up shooting themselves in the foot," Bottelier said.

Analysts believe China will have its own reasons for policy changes like promoting a consumption-based economy and appreciating its currency. The downgrade is expected to have limited impact on how hard or how fast it pursues its initiatives.

"I wouldn't expect this to have any big effect on their policies," Rawski said.

Markets will be waiting to see whether China speeds the rise of the yuan against the dollar to help combat inflation. Last week, the PBOC made the first significant move in months, allowing the yuan to reach its highest level since a currency reform in 2005.

The government has been concerned that a strengthening could hurt China exports. But a two-year-high trade surplus of $31.5 billion in July has allayed those fears, Xinhua said.

Zhou Wangjun, vice director of the National Development and Reform Commission (NDRC) pricing department, voiced concern last week that a new U.S. round of "quantitative easing" would put more dollars in circulation, producing higher commodity prices and "imported inflation."

But after its Aug. 9 meeting, the U.S. Federal Reserve remained silent on the possibility of additional stimulus moves. Markets rebounded sharply after the "Fed" said it expects to keep interest rates at low levels "at least through mid-2013."